Arbitrage – How to Use Your Mortgage as a Wealth Creation Tool

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I am going to contradict what I have said in the past about my views on mortgage debt to articulate why mortgages can be leveraged as wealth creation tools through simple arbitrage.

What is arbitrage? In the simplest terms it is the shuffling of resources from a less favorable outcome to a more favorable income.  For example, buying candy for .50 cents and selling it for $1, or borrowing money at a 4% interest rate and then lending it for 6%. Sounds like what the banks do?

For a long time I believed and preached not carrying any mortgage debt on a personal residential property – in other words your home that you live in. This is still true, but that message is mainly for those who lack discipline or the financial literacy to be able to leverage alternative arbitrage opportunities.

While paying off your mortgage has its benefits, not paying it off also has a significant amount of benefits which I will discuss in this post. The reason why I am specifying the home you live in is because I have been and still am favorable toward good debt incurred to purchase investment property that you can financially benefit from over the long haul.  Investing in real estate is one of my favorite ways to generate passive income and build long term wealth.

Mortgages totally make sense if you have alternative investment opportunities.  What stops many from considering the alternatives is the risk element involved, or potential loss of capital.  While to each their own, this approach in my opinion ends up costing the homeowner not only the opportunity to make exponentially more money on their equity, but also money out of pocket when income taxes and inflation are factored into the equation.

So while many people would rather have their homes paid off and be debt free, the wealthy on the other hand consider themselves debt free based on liquidity on their balance sheets and cash flow to pay off large loans such as a mortgage anytime they wish.  They understand that mortgages are one of the best wealth creation mechanisms and one that can get them to their goal of liquidity the quickest.

Think about it, why would you tie up your cash and eliminate potential tax benefits, often yielding zero net return on equity, when you can invest your money elsewhere?

Fee Simple Mortgages

Another benefit of many mortgages is that one can simply walk away from a mortgage at anytime. Sure you will take a hit on your credit, but who cares when you have loads of liquidity? Need a house next time? No problem, just pay cash. The cash you save on a home purchase today can be invested in instruments yielding higher return on equity.

Can the authorities come after you for the mortgage debt default? Not in most cases. Most mortgage loans are fee simple loans. The lender can ding your credit, but cannot come after you personally and liquidate your assets.  The credit can be repaired in seven years if I am not mistaken. I am not suggesting you draw up your life plan based on these facts, but they are good to know.

Corporations Love to Leverage Arbitrage

Even corporations understand this is the right way to do it. Many large companies have the cash to pay off debt but they do not. They understand the power of leverage. In fact, most companies are highly leveraged! Why? They raise public debt in the form of bonds at 8% and turn around to make 15% on that money. They have it figured out.

Why can’t individuals do the same?  They can.  Those who have invested in their financial literacy can by using  mortgages as wealth creation tools.  A mortgage is not necessarily a bad thing.  It can be used as arbitrage to leverage what you don’t have and yet benefit from compounding returns on equity and tax savings.

Arbitrage Case Study

I like to visualize specific scenarios when I am learning so let’s consider the following:

Let’s say you bought an investment property worth $250,000 with a 20% down payment of $50,000.  By putting down 20%, you have full control over 100% of the asset valued at $250,000.  Highly leveraged? Yes I think.  You cannot do this in the stock market as you can trade of a 50% margin at best.

You can depreciate investment property over 27 years, in this case resulting in a $9,259 deduction per year.  If you are in the 25% tax bracket, the depreciation deduction alone would save you $2,315 in taxes, or roughly 4.6% return on $50,000 of equity.

Assuming a modest 3% appreciation of the property, you will have made an additional $7,500 or roughly 15%, which now puts you at about 19.6% return on $50,000 equity.  Say you paid off $1,500 in principal payments and generated another $2,400 ($200/month) from positive cash flow from rent, you now have an extra $3,900, roughly 7.8%, which brings the total return on equity to a nice 27.4%.

These numbers could be “bloomier” but I have maintained a relative conservative approach for demonstration purposes.

Paying Off Your Mortgage vs. Building Wealth

Let’s walk through another scenario in a slightly different example.  Let’s assume you get a $200,000 interest only mortgage at 7% on a $250,000 property. Assuming you are in the 25% tax bracket, your effective borrowing rate is 5.25%.  Your annual interest expense therefore is $10,500 or $315,000 total cost of borrowing over a 30 year span.

Can you do better by investing the $200,000 in cash elsewhere assuming you had it instead of paying off the mortgage?  Let’s have a look.

$200,000 invested at 8% compounded over 30 years yields a total interest income of $1,812,531. Assuming the same 25% tax bracket, you will have $1,359,398 in your pocket.  I know I know I am assuming an 8% compounded rate which you may have an opinion on despite what all the historical charts say.

I understand that the bitter reality can state otherwise.  That said, there are alternative opportunities for those who have invested in their financial education, such as investing in equity indexed annuities that can realistically yield 8% fixed interest on $200,000 of parked cash or investing overseas at higher risk free interest rates with the understanding there is forex and geopolitical risk.

I purposely did not factor in appreciation of property because this would equally apply to both scenarios. So what is the rush in paying off your mortgage? Would you rather pay it off early or have a few extra million in your bank account down the road?

Let’s look at this in a slightly different way.  If Person A is interested in a interest only mortgage and person B doesn’t believe in mortgages, assuming they have the same net worth today, who will come out ahead financially if both were to purchase a $250,000 property?

Person A

• Current net worth: $250,000
• Buys a home for $250,000
• Pays $50,000 down
• Takes a interest only mortgage for $200,000 at 7%
• Invests the remaining $200,000 of net worth
• Assets = $250,000 home
• Liabilities = $200,000 mortgage loan
• Investments = $200,000 at 8% interest per year

Person B

• Current net worth: $250,000
• Buys a home for $250,000
• Pays $250,000
• Assets = $250,000 home – no debt

Let’s make the following assumptions:

• Appreciation:  4% annual appreciation on property for both homeowners
• Tax bracket:  25% for both homeowners

Let’s have a look at where each Person stands at the end of 30 years.

Person B

• Beginning net worth: $250,000
• 4% annual appreciation over 30 years: $560,849
• Current net worth: $810,849

Person A

• Beginning net worth: $250,000
• 4% annual appreciation over 30 years: $560,849
• 8% ROI on investment, net of 25% tax:  $1,359,398
• Total mortgage interest paid after 25% tax deduction / benefit:  ($315,000)
• Mortgage payoff: ($200,000)
• Current net worth: $1,655,247

Person A is better off by $844,398, or almost a $1 million dollars over a 30 year horizon.

Arbitrage can be so powerful that sometimes you can borrow at a higher interest rate than what you earn and still make money in the long term. Why? Because of the power of compounding. Let’s have a look how.

Say you borrowed $100,000 at 8% interest rate. Assuming you are in the 25% tax bracket, your effective borrowing cost is only 6%.  Your annual interest is therefore $6,000 or $180,000 over 30 years.

Say you are able to earn 6% return on the $100,000, this amounts to a total return of $474,349 over 30 years.  Assuming the same 25% tax bracket, you will keep $355,762 in your pocket after paying uncle Sam. Take out the interest payments of $180,000 and you will have benefited by $175,762 from this simple investment arbitrage.

WOW ? ? ?

Yes I know. The problem is that many just do not view mortgages a wealth creation tool, therefore many financial planners simply don’t include mortgages in their client’s financial strategy. I personally think it is one of the best tax advantaged strategy to create wealth.

I understand this information can take some time to digest and accept, especially if you have never been exposed to this type of an analysis.  We are just not accustomed to view mortgages under this light. Are we missing out?

Can You Still Make Money in Real Estate?

You can arbitrage your way into tons of opportunities in real estate yesterday, today and tomorrow.  It is my opinion that one can make money in real estate in any type of economy or era.  Majority of our Nation’s wealthiest have created more wealth from real estate than any other type of endeavor.

We currently have over 300 million Americans, and this number is projected to surpass 400 million by 2050, which is “just around the corner”.  The demand for real estate is likely to only increase and just like our historical past, real estate will AGAIN be the underlying basis for a heavy bulk of the wealth creation that will take place in the coming years.

I personally love real estate because of the leverage factor, the tax advantages through depreciation and what have you, potential capital gains through property value appreciation and short term cash flow resulting from rents collected.

How do I personally create wealth in real estate? Arbitrage, arbitrage, arbitrage.  You can read my approach to value investing in real estate here.

Concluding Thoughts

When the $hit hits the fan you are actually safer if you have a large mortgage balance relative to someone who has paid a lot into their property.  Why? Banks foreclose on those who have the most equity in their properties first because that is where they can recoup the most amount of their money.

How sad but true.  Those who are fully leveraged (i.e. zero down mortgages) essentially shift all the risk from their personal balance sheets to the banks.  With that said why would one put equity in their home?  Think about it, if you lose your job and don’t have the cash flow coming in any more, no bank will lend to you no matter what kind of equity you have in your home. So what good is all that equity after all? Why are you rushing to pay so fast?

Most people view paying off mortgages as the more conservative approach, but ironically it’s just the other way around. Having the cash, or liquidity to cover emergencies is what sounds more conservative to me.  I’d rather have that cash liquid.

If you are interested in running some numbers, and particularly if you are interested in real estate investing either now or later, I highly recommend two effective tools that will help you crunch the numbers such as ROI return on investment, cap rates, pro forma financials, sensitivity analysis (if/then and “what if” analysis).

These are software packages that are very reasonable in cost and ones which I highly recommend.  They are well worth their nominal cost.

http://www.realdata.com/

http://www.ianalyzerei.com/

Readers: Do you agree or disagree with me? Why? What are some of the pros and cons involved in this kind of arbitrage? Is the risk worth the return in your opinion?

15 Responses to “Arbitrage – How to Use Your Mortgage as a Wealth Creation Tool”

1. krantcents says:

   June 24, 2012 at 10:46 am

   I made a lot of money in income property using the leverage of mortgages, As I increased the rents and equity, I refinanced and took some of the funds to finance another property. I cashed out some 20+ years ago.

   Reply
   • Sunil says:

     June 27, 2012 at 3:04 pm

     great strategy, one that I apply as well. once you have equity and someone willing to lend against it, you can leverage that and keep acquiring. why did you cash out completely?

     Reply
2. Hal says:

   June 27, 2012 at 10:36 am

   I don’t necessarily agree with you that holding a mortgage is an arbitrage opportunity. It is certainly possible to earn more than what you would pay on a mortgage these days, but it is far from a sure thing and probably not a realistic possibility for most people.

   OTOH, I think you are spot on in your analysis that it is much better to be holding cash than to pay off a low-rate mortgage. If you lose your job and can’t make the monthly mortgage payments those extra principal only mortgage payments you made don’t help you at all, and as you pointed out may even make you a bigger target for foreclosure. There is a lot of comfort in knowing that if something happens I can make mortgage and tax payments on my home for several years, certainly worth paying a miniscule 3.25% fixed (after the tax benefit 2.34%) on a 15-year.

   Reply
   • Sunil says:

     June 27, 2012 at 3:00 pm

     good discussion Hal – there is a lot to be said for peace of mind. I agree that the holding of the mortgage of itself is not an arbitrage opportunity, but deciding whether to pay it off vs utilizing the cash in another manner is.

     Reply
3. Romeo says:

   June 27, 2012 at 3:57 pm

   It took me a while to come to your same conclusion, too. I agree that there is no reason to pay a mortgage off early, or any fixed debt for that reason, if the cost of borrowing is low enough. For example, I just got a 1.95% $21,000, 72 month auto loan. I could have paid for the car in full, but I thought, why? I’ll keep my $21,000 in a Intermediate Bond fund. This way, I can hope for at least 5%, but most importantly stay liquid just in case another opportunity comes along.

   Note: You have Person A and Person B swapped incorrectly above.

   Reply
   • Sunil says:

     June 28, 2012 at 4:20 am

     agree. and thanks for pointing out the typo

     Reply
4. gabrielle says:

   June 28, 2012 at 11:18 pm

   Most of the business man did that. They’ll lend from the third part and use them to grow their business; they’re smart they’ll use it wisely.

   Reply
   • Sunil says:

     June 29, 2012 at 3:37 am

     yes indeed. that’s why I love low interest loans such as that you get on credit card balance transfers. you can potentially redeploy the capital a lot more effectively elsewhere 🙂

     Reply
5. Juan says:

   June 30, 2012 at 10:50 am

   The anti-debt, all-interest-payments-are-stupid thinking can really be ridiculous. It is sad that people are ready to demonize debt when they can safely double their ROE.

   Reply
   • Sunil says:

     June 30, 2012 at 2:33 pm

     yes Juan. there is good debt and there is bad debt. I am with you 🙂

     Reply
6. Timothy says:

   July 4, 2012 at 7:13 pm

   Good article. Explained the word “arbitrage” well. Thank you for sharing.

   Reply
   • Sunil says:

     July 5, 2012 at 11:57 am

     welcome Timothy and thanks. how did you find the blog? what are you working on these days?

     Reply
7. Brian says:

   July 1, 2014 at 12:56 am

   Unfortunately, you left out a major component in your calculation for Person B. If person B does not have a mortgage, every dollar that would otherwise go to paying a mortgage can be invested. Just has there is an opportunity cost associated with paying all cash, there is also an opportunity of having to pay a mortgage.

   Reply
8. Jeffrey Schultz says:

   August 20, 2014 at 1:02 pm

   Thank you for this these points are valid. I think this works if you have a deep understanding of finance and are disciplined. Most people are not disciplined enough. For those people a balanced approach works best. Pay a little extra on the mortgage and still put money into other investments.

   Reply
   • Sunil says:

     August 31, 2014 at 10:32 am

     I agree Jeff. It’s not for everyone. The good news is that multiple approaches work well, and one has options based on their personality/appetite

     Reply